CHAPTER ONE

CURRENT LIABILITIES AND CONTINGENCIES

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WHAT IS A LIABILITY?
The FASB, as part of its conceptual framework study, defined liabilities as “probable future
sacrifices of economic benefits arising from present obligations of a particular entity to transfer
assets or provide services to other entities in the future as a result of past transactions or
events.” In other words, a liability has three essential characteristics:
1. It is a present obligation that entails settlement by probable future transfer or use of cash,
goods, or services.
2. It is an unavoidable obligation.
3. The transaction or other event creating the obligation has already occurred.
Because liabilities involve future disbursements of assets or services, one of their most
important features is the date on which they are payable. A company must satisfy currently
maturing obligations in the ordinary course of business to continue operating. Liabilities with a
more distant due date do not, as a rule, represent a claim on the company’s current resources.
They are therefore in a slightly different category.
This feature gives rise to the basic division of liabilities into (1) current liabilities and (2) long-
term debt.

WHAT IS A CURRENT LIABILITY?

Recall that current assets are cash or other assets that companies reasonably expect to convert
into cash, sell, or consume in operations within a single operating cycle or within a year (if
completing more than one cycle each year). Current liabilities are “obligations whose
liquidation is reasonably expected to require use of existing resources properly classified as
current assets, or the creation of other current liabilities.”This definition has gained wide
acceptance because it recognizes operating cycles of varying lengths in different industries. This
definition also considers the important relationship between current assets and current liabilities.

The operating cycle is the period of time elapsing between the acquisition of goods and
services involved in the manufacturing process and the final cash realization resulting from
sales and subsequent collections. Industries that manufacture products requiring an aging
process, and certain capital-intensive industries, have an operating cycle of considerably more
than one year. On the other hand, most retail and service establishments have several operating
cycles within a year.
Here are some typical current liabilities:
1. Accounts payable. 6. Customer advances and deposits.
2. Notes payable. 7. Unearned revenues.
3. Current maturities of long-term debt. 8. Sales taxes payable.
4. Short-term obligations expected to be 9. Income taxes payable.
refinanced. 10. Employee-related liabilities.
5. Dividends payable.
Accounts Payable
Accounts payable, or trade accounts payable, is balances owed to others for goods, supplies,
or services purchased on open account. Accounts payable arise because of the time lag between
the receipt of services or acquisition of title to assets and the payment for them. The terms of the
sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state this period of extended credit, commonly 30
to 60 days.
Most companies record liabilities for purchases of goods upon receipt of the goods. If title has
passed to the purchaser before receipt of the goods, the company should record the transaction
at the time of title passage. A company must pay special attention to transactions occurring near
the end of one accounting period and at the beginning of the next. It needs to ascertain that the
record of goods received (the inventory) agrees with the liability (accounts payable), and that it
records both in the proper period.
Notes Payable
Notes payable are written promises to pay a certain sum of money on a specified future date.
They may arise from purchases, financing, or other transactions. Some industries require notes
(often referred to as trade notes payable) as part of the sales/ purchases transaction in lieu of
the normal extension of open account credit. Notes payable to banks or loan companies
generally arise from cash loans. Companies classify notes as short-term or long-term, depending
on the payment due date. Notes may also be interest-bearing or zero-interest-bearing.

Interest-Bearing Note Issued

Assume that Castle National Bank agrees to lend $100,000 on March 1, 2010, to Landscape Co.
if Landscape signs a $100,000, 6 percent, four-month note. Landscape records the cash received
on March 1 as follows:
March 1 Cash 100,000
Notes Payable 100,000
(To record issuance of 6%, 4-month note to Castle National Bank)
If Landscape prepares financial statements semi annually, it makes the following adjusting entry
to recognize interest expense and interest payable of $2,000 ($100,000 x 6% x 4/12) at June 30:
June 30 Interest Expense 2,000
Interest Payable 2,000
(To accrue interest for 4 months on Castle National Bank note)
If Landscape prepares financial statements monthly, its adjusting entry at the end of each month
is $500 ($100,000 x 6% x 1/12).
At maturity (July 1), Landscape must pay the face value of the note ($100,000) plus $2,000
interest ($100,000 x 6% x 4/12). Landscape records payment of the note and accrued interest as
follows.
July 1 Notes Payable 100,000
Interest Payable 2,000
Cash 102,000
(To record payment of Castle National Bank interest bearing note and accrued interest at
maturity)
Zero-Interest-Bearing Note Issued
A company may issue a zero-interest-bearing note instead of an interest-bearing note.
A zero-interest-bearing note does not explicitly state an interest rate on the face of the note.
Interest is still charged, however. At maturity the borrower must pay back an amount greater
than the cash received at the issuance date. In other words, the borrower receives in cash the
present value of the note. The present value equals the face value of the note at maturity minus
the interest or discount charged by the lender for the term of the note. In essence, the bank takes
its fee “up front” rather than on the date the note matures.
To illustrate, assume that Landscape issues a $102,000, four-month, zero-interest bearing note
to Castle National Bank. The present value of the note is $100,000. Landscape records this
transaction as follows.
March 1 Cash 100,000
Discount on Notes Payable 2,000
Notes Payable 102,000
(To record issuance of 4-month, zero-interest-bearing note to Castle National Bank)
Landscape credits the Notes Payable account for the face value of the note, which is $2,000
more than the actual cash received. It debits the difference between the cash received and the
face value of the note to Discount on Notes Payable. Discount on Notes Payable is a contra
account to Notes Payable, and therefore is subtracted from Notes Payable on the balance
sheet.

The following shows the balance sheet presentation on March 1.

Current liabilities:
Notes payable $102,000
Less: Discount on notes payable 2,000 $100,000
The amount of the discount, $2,000 in this case, represents the cost of borrowing $100,000 for 4
months. Accordingly, Landscape charges the discount to interest expense over the life of the
note. That is, the Discount on Notes Payable balance represents interest expense chargeable
to future periods. Thus, Landscape should not debit Interest Expense for $2,000 at the time of
obtaining the loan.
Current Maturities of Long-Term Debt
Companies report as part of their current liabilities the portion of bonds, mortgage notes, and
other long-term indebtedness that matures within the next fiscal year. They categorizes this
amount as current maturities of long-term debt. But Companies exclude long-term debts
maturing currently as current liabilities if they are to be:
1. Retired by assets accumulated for this purpose that properly have not been shown as
current assets,
2. Refinanced, or retired from the proceeds of a new debt issue, or
3. Converted into capital stock.
In these situations, the use of current assets or the creation of other current liabilities does not
occur. Therefore, classification as a current liability is inappropriate. A company should
disclose the plan for liquidation of such a debt either parenthetically or by a note to the financial
statements. When only a part of a long-term debt is to be paid within the next 12 months, as in
the case of serial bonds that it retires through a series of annual installments, the company
reports the maturing portion of long-term debt as a current liability, and the remaining
portion as a long-term debt.
However, a company should classify as current any liability that is due on demand (callable by
the creditor) or will be due on demand within a year (or operating cycle, if longer). Liabilities
often become callable by the creditor when there is a violation of the debt agreement. For
example, most debt agreements specify a given level of equity to debt be maintained, or specify
that working capital be of a minimum amount.
If the company violates an agreement, it must classify the debt as current because it is a
reasonable expectation that existing working capital will be used to satisfy the debt. Only if a
company can show that it is probable that it will cure (satisfy) the violation within the grace
period specified in the agreements can it classify the debt as non current.

Short-Term Obligations Expected to Be Refinanced

Short-term obligations are debts scheduled to mature within one year after the date of a
company’s balance sheet or within its operating cycle, whichever is longer. Some short-term
obligations are expected to be refinanced on a long-term basis. These short-term obligations
will not require the use of working capital during the next year (or operating cycle).
At one time, the accounting profession generally supported the exclusion of short term
obligations from current liabilities if they were “expected to be refinanced.” But the profession
provided no specific guidelines, so companies determined whether a short-term obligation was
“expected to be refinanced” based solely on management’s intent to refinance on a long-term
basis. Classification was not clear-cut. For example, a company might obtain a five-year bank
loan but handle the actual financing with 90-day notes, which it must keep turning over
(renewing). In this case, is the loan a long-term debt or a current liability? Another example was
the Penn Central Rail road before it went bankrupt. The rail road was deep into short-term
debt but classified it as long-term debt. Why? Because the rail road believed it had
commitments from lenders to keep refinancing the short-term debt. When those commitments
suddenly disappeared, it was “good-bye Pennsy.” As the Greek philosopher Epictetus once said,
“Some things in this world are not and yet appear to be.”

Refinancing Criteria
To resolve these classification problems, the accounting profession has developed authoritative
criteria for determining the circumstances under which short-term obligations may be properly
excluded from current liabilities. A company is required to exclude a short-term obligation from
current liabilities if both of the following conditions are met:
1. It must intend to refinance the obligation on a long-term basis.
2. It must demonstrate an ability to consummate the refinancing.
Intention to refinance on a long-term basis means that the company intends to refinance the
short-term obligation so that it will not require the use of working capital during the ensuing
fiscal year (or operating cycle, if longer).
The company demonstrates the ability to consummate the refinancing by:
 (a) Actually refinancing the short-term obligation by issuing a long-term obligation or
equity securities after the date of the balance sheet but before it is issued; or
(b) Entering into a financing agreement that clearly permits the company to refinance the
debt on a long-term basis on terms that are readily determinable.
If an actual refinancing occurs, the portion of the short-term obligation to be excluded from
current liabilities may not exceed the proceeds from the new obligation or equity securities used
to retire the short-term obligation. For example, Montavon Winery had $3,000,000 of short-
term debt. Subsequent to the balance sheet date, but before issuing the balance sheet, the
company issued 100,000 shares of common stock, intending to use the proceeds to liquidate the
short-term debt at its maturity. If Montavon’s net proceeds from the sale of the 100,000 shares
total $2,000,000, it can exclude from current liabilities only $2,000,000 of the short-term debt.
An additional question is whether a company should exclude from current liabilities a short-
term obligation if it is paid off after the balance sheet date and replaced by long-term debt
before the balance sheet is issued. To illustrate, Marquardt Company pays off short-term debt of
$40,000 on January 17, 2011, and issues long-term debt of $100,000 on February 3, 2011.
Marquardt’s financial statements, dated December 31, 2010, are to be issued March 1, 2011.
Should Marquardt exclude the $40,000 short-term debt from current liabilities? No—here’s
why: Repayment of the short-term obligation required the use of existing current assets before
the company obtained funds through long-term financing. Therefore, Marquardt must include
the short-term obligations in current liabilities at the balance sheet date (see graphical
presentation below).

Dividends Payable
A cash dividend payable is an amount owed by a corporation to its stockholders as a result of
board of directors’ authorization. At the date of declaration the corporation assumes a liability
that places the stockholders in the position of creditors in the amount of dividends declared.
Because companies always pay cash dividends within one year of declaration (generally within
three months), they classify them as current liabilities.
On the other hand, companies do not recognize accumulated but undeclared dividends on
cumulative preferred stock as a liability. Why? Because preferred dividends in arrears are not
an obligation until the board of directors authorizes the payment. Nevertheless, companies
should disclose the amount of cumulative dividends unpaid in a note, or show it parenthetically
in the capital stock section.
Dividends payable in the form of additional shares of stock are not recognized as a liability.
Such stock dividends do not require future outlays of assets or services. Companies generally
report such undistributed stock dividends in the stockholders’ equity section because they
represent retained earnings in the process of transfer to paid-in capital.

Customer Advances and Deposits

Current liabilities may include returnable cash deposits received from customers and
employees. Companies may receive deposits from customers to guarantee performance of a
contract or service or as guarantees to cover payment of expected future obligations.
For example, a company like Alltel Corp. often requires a deposit on equipment that customers
use to connect to the Internet or to access its other services. Alltel also may receive deposits
from customers as guarantees for possible damage to property.
Additionally, some companies require their employees to make deposits for the return of keys
or other company property.
The classification of these items as current or non current liabilities depends on the time
between the date of the deposit and the termination of the relationship that required the deposit.

Unearned Revenues
A magazine publisher receives payment when a customer subscribes to its magazines. An
airline company sells tickets for future flights. And software companies, issue coupons that
allow customers to upgrade to the next version of their software. How do these companies
account for unearned revenues that they receive before delivering goods or rendering services?
1. Upon receipt of the advance, debit Cash, and credit a current liability account
identifying the source of the unearned revenue.
2. Upon earning the revenue, debit the unearned revenue account, and credit an earned
revenue account.
To illustrate, assume that Allstate University sells 10,000 season football tickets at $50 each for
its five-game home schedule. Allstate University records the sales of season tickets as follows:
August 6 Cash 500,000
Unearned Football Ticket Revenue 500,000
(To record sale of 10,000 season tickets)
After each game, Allstate University makes the following entry.
September 7 Unearned Football Ticket Revenue 100,000
Football Ticket Revenue 100,000
(To record football ticket revenues earned)
Unearned Football Ticket Revenue is, therefore, unearned revenue. Allstate University reports it
as a current liability in the balance sheet. As revenue is earned, a transfer from unearned
revenue to earned revenue occurs. Unearned revenue is material for some companies: In the
airline industry, tickets sold for future flights represent almost 50 percent of total current
liabilities.
The following illustration shows specific unearned and earned revenue accounts used in
selected types of businesses.
The balance sheet should report obligations for any commitments that are redeemable in goods
and services. The income statement should report revenues earned during the period.

Sales Taxes Payable

Retailers like Wal-Mart, Circuit City, and GAP must collect sales taxes from customers on
transfers of tangible personal property and on certain services and then must remit these taxes to
the proper governmental authority. GAP, for example, sets up a liability to provide for taxes
collected from customers but not yet remitted to the tax authority.
The Sales Taxes Payable account should reflect the liability for sales taxes due various
governments. The entry below illustrates use of the Sales Taxes Payable account on a sale of
$3,000 assuming a 4 percent sales tax is in effect.
Cash or Accounts Receivable 3,120
Sales 3,000
Sales Taxes Payable 120

Income Taxes Payable

Corporations should classify as a current liability the taxes payable on net income, as computed
per the tax return. Unlike a corporation, proprietorships and partnerships are not taxable entities.
Because the individual proprietor and the members of a partnership are subject to personal
income taxes on their share of the business’s taxable income, income tax liabilities do not
appear on the financial statements of proprietorships and partnerships.
Most corporations must make periodic tax payments throughout the year in an authorized bank
depository or a Federal Reserve Bank. These payments are based upon estimates of the total
annual tax liability. As the estimated total tax liability changes, the periodic contributions also
change. If in a later year the taxing authority assesses an additional tax on the income of an
earlier year, the company should credit Income
Taxes Payable and charge the related debit to current operations. Differences between taxable
income under the tax laws and accounting income under generally accepted accounting
principles sometimes occur. Because of these differences, the amount of income tax payable to
the government in any given year may differ substantially from income tax expense as reported
on the financial statements.
.
Employee-Related Liabilities
Companies also report as a current liability amounts owed to employees for salaries or wages at
the end of an accounting period. In addition, they often also report as current liabilities the
following items related to employee compensation.
1. Payroll deductions.
2. Compensated absences.
3. Bonuses.

Payroll Deductions
The most common types of payroll deductions are taxes, insurance premiums, employee
savings, and union dues. To the extent that a company has not remitted the amounts deducted to
the proper authority at the end of the accounting period, it should recognize them as current
liabilities.

Compensated Absences
Compensated absences are paid absences from employment—such as vacation, illness, and
holidays. Companies should accrue a liability for the cost of compensation for future absences
if all of the following conditions exist.
(a) The employer’s obligation relating to employees’ rights to receive compensation for
future absences is attributable to employees’ services already rendered.
(b) The obligation relates to the rights that vest or accumulate.
(c) Payment of the compensation is probable.
(d) The amount can be reasonably estimated.
The illustration follow shows an example of an accrual for compensated absences, in an excerpt
from the balance sheet of Clarcor Inc.

If an employer meets conditions (a), (b), and (c) but does not accrue a liability because of a
failure to meet condition (d), it should disclose that fact. The following presentation shows an
example of such a disclosure, in a note from the financial statements of Gotham Utility
Company.
The following considerations are relevant to the accounting for compensated absences.
Vested rights exist when an employer has an obligation to make payment to an employee even
after terminating his or her employment. Thus, vested rights are not contingent on an
employee’s future service. Accumulated rights are those that employees can carry forward to
future periods if not used in the period in which earned. For example, assume that you earn four
days of vacation pay as of December 31, the end of your employer’s fiscal year. Company
policy is that you will be paid for this vacation time even if you terminate employment. In this
situation, your four days of vacation pay are vested, and your employer must accrue the amount.
Now assume that your vacation days are not vested, but that you can carry the four days over
into later periods. Although the rights are not vested, they are accumulated rights for which the
employer must make an accrual. However, the amount of the accrual is adjusted to allow for
estimated forfeitures due to turnover.
A modification of the general rules relates to the issue of sick pay. If sick pay benefits vest, a
company must accrue them. If sick pay benefits accumulate but do not vest, a company may
choose whether to accrue them. Why this distinction? Companies may administer compensation
designated as sick pay in one of two ways. In some companies, employees receive sick pay only
if illness causes their absence. Therefore, these companies may or may not accrue a liability
because its payment depends on future employee illness. Other companies allow employees to
accumulate unused sick pay and take compensated time off from work even when not ill. For
this type of sick pay, a company must accrue a liability because the company will pay it,
regardless of whether employees become ill. Companies should recognize the expense and
related liability for compensated absences in the year earned by employees.

Bonus Agreements
Many companies give a bonus to certain or all employees in addition to their regular salaries or
wages. Frequently the bonus amount depends on the company’s yearly profit. A company may
consider bonus payments to employees as additional wages and should include them as a
deduction in determining the net income for the year.
To illustrate the entries for an employee bonus, assume that Palmer Inc. shows income for the
year 2010 of $100,000. It will pay out bonuses of $10,700 in January 2011. Palmer makes an
adjusting entry dated December 31, 2010, to record the bonuses as follows:
Employees’ Bonus Expense 10,700
Profit-Sharing Bonus Payable 10,700
In January 2011, when Palmer pays the bonus, it makes this journal entry:
Profit-Sharing Bonus Payable 10,700
Cash 10,700
Palmer should show the expense account in the income statement as an operating expense. The
liability, Profit-Sharing Bonus Payable, is usually payable within a short period of time.
Companies should include it as a current liability in the balance sheet. Similar to bonus
agreements are contractual agreements for conditional expenses.
Examples would be agreements covering rents or royalty payments conditional on the amount
of revenues earned or the quantity of product produced or extracted. Conditional expenses
based on revenues or units produced are usually less difficult to compute than bonus
arrangements.
For example, assume that a lease calls for a fixed rent payment of $500 per month and 1 percent
of all sales over $300,000 per year. The company’s annual rent obligation would amount to
$6,000 plus $0.01 of each dollar of revenue over $300,000. Or, a royalty agreement may give to
a patent owner $1 for every ton of product resulting from the patented process, or give to a
mineral rights owner $0.50 on every barrel of oil extracted. As the company produces or
extracts each additional unit of product, it creates an additional obligation, usually a current
liability.

CONTINGENCIES
Companies often are involved in situations where uncertainty exists about whether an obligation
to transfer cash or other assets has arisen and/or the amount that will be required to settle the
obligation. For example:
 Merck may be a defendant in a lawsuit, and any payment is contingent upon the outcome of
a settlement or an administrative or court proceeding.
 Ford Motor Co. provides a warranty for a car it sells, and any payments are contingent on
the number of cars that qualify for benefits under the warranty.
 Briggs & Stratton acts as a guarantor on a loan for another entity, and any payment is
contingent on whether the other entity defaults.
Broadly, these situations are called contingencies. A contingency is “an existing condition,
situation, or set of circumstances involving uncertainty as to possible gain (gain contingency)
or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more
future events occur or fail to occur.”

GAIN CONTINGENCIES
Gain contingencies are claims or rights to receive assets (or have a liability reduced) whose
existence is uncertain but which may become valid eventually. The typical gain contingencies
are:
1. Possible receipts of monies from gifts, donations, bonuses, and so on.
2. Possible refunds from the government in tax disputes.
3. Pending court cases with a probable favourable outcome.
4. Tax loss carry forwards.
Companies follow a conservative policy in this area. Except for tax loss carry forwards, they do
not record gain contingencies. A company discloses gain contingencies in the notes only when a
high probability exists for realizing them. As a result, it is unusual to find information about
contingent gains in the financial statements and the accompanying notes. The following excerpt
presents an example of a gain contingency disclosure.

LOSS CONTINGENCIES
Loss contingencies involve possible losses. A liability incurred as a result of a loss contingency
is by definition a contingent liability. Contingent liabilities depend on the occurrence of one or
more future events to confirm either the amount payable, the payee, the date payable, or its
existence. That is, these factors depend on a contingency.

Likelihood of Loss
When a loss contingency exists, the likelihood that the future event or events will confirm the
incurrence of a liability can range from probable to remote. The FASB uses the terms probable,
reasonably possible, and remote to identify three areas within that range and assigns the
following meanings.
 Probable. The future event or events are likely to occur.
 Reasonably possible. The chance of the future event or events occurring is more than
remote but less than likely.
 Remote. The chance of the future event or events occurring is slight.
Companies should accrue an estimated loss from a loss contingency by a charge to expense and
a liability recorded only if both of the following conditions are met.
1. Information available prior to the issuance of the financial statements indicates that it is
probable that a liability has been incurred at the date of the financial statements.
2. The amount of the loss can be reasonably estimated.
To record a liability, a company does not need to know the exact payee nor the exact date
payable. What a company must know is whether it is probable that it incurred a liability.
To meet the second criterion, a company needs to be able to reasonably determine an amount
for the liability. To determine a reasonable estimate of the liability, a company may use its own
experience, experience of other companies in the industry, engineering or research studies, legal
advice, or educated guesses by qualified personnel.
The following illustration shows an accrual recorded for a loss contingency, from the annual
report of Quaker State Oil Refining Company.
Use of the terms probable, reasonably possible, and remote to classify contingencies involves
judgement and subjectivity. The following table lists examples of loss contingencies and the
general accounting treatment accorded them.

Practicing accountants express concern over the diversity that now exists in the interpretation of
“probable,” “reasonably possible,” and “remote.” Current practice relies heavily on the exact
language used in responses received from lawyers (such language is necessarily biased and
protective rather than predictive). As a result, accruals and disclosures of contingencies vary
considerably in practice. Some of the more common loss contingencies are:
1. Litigation, claims, and assessments. 3. Premiums and coupons.
2. Guarantee and warranty costs. 4. Environmental liabilities.

As discussed in the opening story, companies do not record or report in the notes to the
financial statements general risk contingencies inherent in business operations
(e.g., the possibility of war, strike, uninsurable catastrophes, or a business recession).
Litigation, Claims, and Assessments
Companies must consider the following factors, among others, in determining whether to record
a liability with respect to pending or threatened litigation and actual or possible Claims and
assessments.
1. The time period in which the underlying cause of action occurred.
2. The probability of an unfavourable outcome.
3. The ability to make a reasonable estimate of the amount of loss.
To report a loss and a liability in the financial statements, the cause for litigation must have
occurred on or before the date of the financial statements. It does not matter that the
company became aware of the existence or possibility of the lawsuit or claims after the date of
the financial statements but before issuing them. To evaluate the probability of an unfavourable
outcome, a company considers the following: the nature of the litigation; the progress of the
case; the opinion of legal counsel; its own and others’ experience in similar cases; and any
management response to the lawsuit.
Companies can seldom predict the outcome of pending litigation, however, with any assurance.
And, even if evidence available at the balance sheet date does not favor the company, it is
hardly reasonable to expect the company to publish in its financial statements a dollar estimate
of the probable negative outcome. Such specific disclosures might weaken the company’s
position in the dispute and encourage the plaintiff to intensify its efforts.

With respect to unfiled suits and un asserted claims and assessments, a company must
determine (1) the degree of probability that a suit may be filed or a claim or assessment may be
asserted, and (2) the probability of an unfavourable outcome.

Guarantee and Warranty Costs

A warranty (product guarantee) is a promise made by a seller to a buyer to make good on a
deficiency of quantity, quality, or performance in a product. Manufacturers commonly use it as
a sales promotion technique. Auto makers, for instance, “hyped” their sales by extending their
new-car warranty to seven years or 100,000 miles. For a specified period of time following the
date of sale to the consumer, the manufacturer may promise to bear all or part of the cost of
replacing defective parts, to perform any necessary repairs or servicing without charge, to
refund the purchase price, or even to “double your money back.”
Warranties and guarantees entail future costs. These additional costs, sometimes called “after
costs” or “post-sale costs,” frequently are significant. Although the future cost is indefinite as to
amount, due date, and even customer, a liability is probable in most cases. Companies should
recognize this liability in the accounts if they can reasonably estimate it. The estimated amount
of the liability includes all the costs that the company will incur after sale and delivery and that
are incident to the correction of defects or deficiencies required under the warranty provisions.
Warranty costs are a classic example of a loss contingency. Companies use two basic methods
of accounting for warranty costs: (1) the cash basis method and (2) the accrual method.
Cash Basis
Under the cash-basis method, companies expense warranty costs as incurred. In other words, a
seller or manufacturer charges warranty costs to the period in which it complies with the
warranty. The company does not record a liability for future costs arising from warranties, nor
does it charge the period of sale. Companies frequently justify use of this method, the only one
recognized for income tax purposes, on the basis of expediency when warranty costs are
immaterial or when the warranty period is relatively short. A company must use the cash-basis
method when it does not accrue a warranty liability in the year of sale either because:
1. it is not probable that a liability has been incurred, or
2. it cannot reasonably estimate the amount of the liability.

Accrual Basis
If it is probable that customers will make warranty claims and a company can reasonably
estimate the costs involved, the company must use the accrual method.
Under the accrual method, companies charge warranty costs to operating expense in the year
of sale. The accrual method is the generally accepted method. Companies should use it
whenever the warranty is an integral and inseparable part of the sale and is viewed as a loss
contingency. We refer to this approach as the expense warranty approach.
Example of Expense Warranty Approach. To illustrate the expense warranty method, assume
that Denson Machinery Company begins production on a new machine in July 2010, and sells
100 units at $5,000 each by its year-end, December 31, 2010. Each machine is under warranty
for one year. Denson estimates based on past experience with a similar machine, that the
warranty cost will average $200 per unit. Further, as a result of parts replacements and services
rendered in compliance with machinery warranties, it incurs $4,000 in warranty costs in 2010
and $16,000 in 2011.
1. Sale of 100 machines at $5,000 each, July through December 2010:
Cash or Accounts Receivable 500,000
Sales 500,000
2. Recognition of warranty expense, July through December 2010:
Warranty Expense 4,000
Cash, Inventory, Accrued Payroll 4,000
(Warranty costs incurred)
Warranty Expense 16,000
Liability under Warranties 16,000
(To accrue estimated warranty costs)
The December 31, 2010, balance sheet reports “Estimated liability under warranties” as a
current liability of $16,000, and the income statement for 2010 reports “Warranty expense” of
$20,000.
3. Recognition of warranty costs incurred in 2011 (on 2010 machinery sales):
Liability under Warranties 16,000
Cash, Inventory, Accrued Payroll 16,000
(Warranty costs incurred)
If Denson Machinery applies the cash-basis method, it reports $4,000 as warranty expense in
2010 and $16,000 as warranty expense in 2011. It records all of the sale price as revenue in
2010. In many instances, application of the cash-basis method fails to match the warranty costs
relating to the products sold during a given period with the revenues derived from such products.
As such, it violates the expense recognition principle. Where ongoing warranty policies exist
year after year, the differences between the cash and the expense warranty bases probably
would not be so great.

Sales Warranty Approach. A warranty is sometimes sold separately from the product.
For example, when you purchase a television set or DVD player, you are entitled to the
manufacturer’s warranty. You also will undoubtedly be offered an extended warranty on the
product at an additional cost.
In this case, the seller should recognize separately the sale of the television or DVD player, with
the manufacturer’s warranty and the sale of the extended warranty.
This approach is referred to as the sales warranty approach. Companies defer revenue on
the sale of the extended warranty and generally recognize it on a straight-line basis over the
life of the contract. The seller of the warranty defers revenue because it has an obligation to
perform services over the life of the contract. The seller should only defer and amortize costs
that vary with and are directly related to the sale of the contracts (mainly commissions). It
expenses those costs, such as employees’ salaries, advertising, and general and administrative
expenses, that it would have incurred even if it did not sell a contract.
To illustrate, assume you purchase a new auto mobile from Hanlin Auto for $20,000. In
addition to the regular warranty on the auto (the manufacturer will pay for all repairs for the
first 36,000 miles or three years, whichever comes first), you purchase at a cost of $600 an
extended warranty that protects you for an additional three years or 36,000 miles. Hanlin Auto
records the sale of the auto mobile (with the regular warranty) and the sale of the extended
warranty on January 2, 2010, as follows:
Cash 20,600
Sales 20,000
Unearned Warranty Revenue 600
It recognizes revenue at the end of the fourth year (using straight-line amortization) as
follows.
Unearned Warranty Revenue 200
Warranty Revenue 200
Because the extended warranty contract only starts after the regular warranty expires, Hanlin
Auto defers revenue recognition until the fourth year. If it incurs the costs of performing
services under the extended warranty contract on other than a straight-line basis (as historical
evidence might indicate), Hanlin Auto should recognize revenue over the contract period in
proportion to the costs it expected to incur in performing services under the contract.

Premiums and Coupons

Numerous companies offer premiums (either on a limited or continuing basis) to customers in
return for boxtops, certificates, coupons, labels, or wrappers. The premium may be silverware,
dishes, a small appliance, a toy, or free transportation. Also, printed coupons that can be
redeemed for a cash discount on items purchased are extremely popular. A more recent
marketing innovation is the cash rebate, which the buyer can obtain by returning the store
receipt, a rebate coupon, and Universal Product Code (UPC label) or “bar code” to the
manufacturer.
Companies offer premiums, coupon offers, and rebates to stimulate sales. Thus companies
should charge the costs of premiums and coupons to expense in the period of the sale that
benefits from the plan. The period that benefits is not necessarily the period in which the
company offered the premium. At the end of the accounting period many premium offers may
be outstanding and must be redeemed when presented in subsequent periods. In order to reflect
the existing current liability and to match costs with revenues, the company estimates the
number of outstanding premium offers that customers will present for redemption. The
company then charges the cost of premium offers to Premium Expense. It credits the
outstanding obligations to an account titled Liability for Premiums or Premium Liability.
The following example illustrates the accounting treatment for a premium offer. Fluffy
Cakemix Company offered its customers a large non breakable mixing bowl in exchange for 25
cents and 10 boxtops. The mixing bowl costs Fluffy Cakemix Company 75 cents, and the
company estimates that customers will redeem 60 percent of the boxtops.
The premium offer began in June 2010 and resulted in the transactions journalized below.
Fluffy Cakemix Company records purchase of 20,000 mixing bowls at 75 cents as follows.
Inventory of Premium Mixing Bowls 15,000
Cash 15,000
The entry to record sales of 300,000 boxes of cake mix at 80 cents would be:
Cash 240,000
Sales 240,000
Fluffy records the actual redemption of 60,000 boxtops, the receipt of 25 cents per 10 boxtops,
and the delivery of the mixing bowls as follows.
Cash [(60,000 / 10) x $0.25] 1,500
Premium Expense 3,000
Inventory of Premium Mixing Bowls 4,500
Computation: (60,000 _ 10) _ $0.75 _ $4,500
Finally, Fluffy makes an end-of-period adjusting entry for estimated liability for outstanding
premium offers (boxtops) as follows.
Premium Expense 6,000
Liability for Premiums 6,000
Computation:
Total boxtops sold in 2010 300,000
Total estimated redemptions (60%) 180,000
Boxtops redeemed in 2010 60,000
Estimated future redemptions 120,000
Cost of estimated claims outstanding
(120,000 / 10) x ($0.75 _ $0.25) = $6,000
The December 31, 2010, balance sheet of Fluffy Cakemix Company reports an “Inventory of
premium mixing bowls” of $10,500 as a current asset and “Liability for premiums” of $6,000 as
a current liability. The 2010 income statement reports a $9,000 “Premium expense” among the
selling expenses.
Environmental Liabilities
Estimates to clean up existing toxic waste sites total upward of $752 billion over a 30-year
period. In addition, cost estimates of cleaning up our air and preventing future deterioration of
the environment run even higher. Consider some average environmental costs per company for
various industries:

These costs are likely to only grow, considering “Super fund legislation.” This federal
legislation provides the Environmental Protection Agency (EPA) with the power to clean up
waste sites and charge the clean-up costs to parties the EPA deems responsible for
contaminating the site. These potentially responsible parties can have a significant liability.
In many industries, the construction and operation of long-lived assets involves obligations for
the retirement of those assets. When a mining company opens up a strip mine, it may also
commit to restore the land once it completes mining. Similarly, when an oil company erects an
offshore drilling platform, it may be legally obligated to dismantle and remove the platform at
the end of its useful life.

Accounting Recognition of Asset Retirement Obligations

A company must recognize an asset retirement obligation (ARO) when it has an existing legal
obligation associated with the retirement of a long-lived asset and when it can reasonably
estimate the amount of the liability. Companies should record the ARO at fair value.
Obligating Events. Examples of existing legal obligations, which require recognition of a
liability include, but are not limited to:
• decommissioning nuclear facilities,
• dismantling, restoring, and reclamation of oil and gas properties,
• certain closure, reclamation, and removal costs of mining facilities,
• closure and post-closure costs of landfills.
In order to capture the benefits of these long-lived assets, the company is generally legally
obligated for the costs associated with retirement of the asset, whether the company hires
another party to perform the retirement activities or performs the activities with its own
workforce and equipment. AROs give rise to various recognition patterns. For example, the
obligation may arise at the outset of the asset’s use (e.g., erection of an oil-rig), or it may build
over time (e.g., a landfill that expands over time).
Measurement. A company initially measures an ARO at fair value, which is defined as the
amount that the company would pay in an active market to settle the ARO. While active
markets do not exist for many AROs, companies should estimate fair value based on the best
information available. Such information could include market prices of similar liabilities, if
available. Alternatively, companies may use present value techniques to estimate fair value.
Recognition and Allocation. To record an ARO in the financial statements, a company includes
the cost associated with the ARO in the carrying amount of the related long-lived asset, and
records a liability for the same amount. It records an asset retirement cost as part of the related
asset because these costs are tied to operating the asset and are necessary to prepare the asset for
its intended use. Therefore, the specific asset (e.g., mine, drilling platform, nuclear power plant)
should be increased because the future economic benefit comes from the use of this productive
asset.
Companies should not record the capitalized asset retirement costs in a separate account
because there is no future economic benefit that can be associated with these costs alone.
In subsequent periods, companies allocate the cost of the ARO to expense over the period of the
related asset’s useful life. Companies may use the straight-line method for this allocation, as
well as other systematic and rational allocations.
Example of ARO Accounting Provisions. To illustrate the accounting for AROs, assume that
on January 1, 2010, Wildcat Oil Company erected an oil platform in the Gulf of
Mexico. Wildcat is legally required to dismantle and remove the platform at the end of its
useful life, estimated to be five years. Wildcat estimates that dismantling and removal will cost
$1,000,000. Based on a 10 percent discount rate, the fair value of the asset retirement obligation
is estimated to be $620,920 ($1,000,000 _ .62092). Wildcat records this ARO as follows.
January 1, 2010 Drilling Platform 620,920
Asset Retirement Obligation 620,920
During the life of the asset, Wildcat allocates the asset retirement cost to expense.
Using the straight-line method, Wildcat makes the following entries to record this expense.
December 31, 2010, 2011, 2012, 2013, 2014
Depreciation Expense ($620,920 / 5) 124,184
Accumulated Depreciation 124,184
In addition, Wildcat must accrue interest expense each period. Wildcat records interest expense
and the related increase in the asset retirement obligation on December 31, 2010, as follows.
December 31, 2010
Interest Expense ($620,920 x 10%) 62,092
Asset Retirement Obligation 62,092
On January 10, 2015, Wildcat contracts with Rig Reclaimers, Inc. to dismantle the platform at a
contract price of $995,000. Wildcat makes the following journal entry to record settlement of
the ARO.
January 10, 2015
Asset Retirement Obligation 1,000,000
Gain on Settlement of ARO 5,000
Cash 995,000
Companies need to provide more extensive disclosure regarding environmental liabilities. In
addition, companies should record more of these liabilities. The SEC believes that companies
should not delay recognition of a liability due to significant uncertainty. The SEC argues that if
the liability is within a range, and no amount within the range is the best estimate, then
management should recognize the minimum amount of the range. That treatment is in
accordance with GAAP. The SEC also believes that companies should report environmental
liabilities in the balance sheet independent of recoveries from third parties. Thus, companies
may not net possible insurance recoveries against liabilities but must show them separately.
Because there is much litigation regarding recovery of insurance proceeds, these “assets” appear
to be gain contingencies. Therefore, companies should not report these on the balance sheet.

Self-Insurance
As discussed earlier, contingencies are not recorded for general risks (e.g., losses that might
arise due to poor expected economic conditions). Similarly, companies do not record
contingencies for more specific future risks such as allowances for repairs. The reason: These
items do meet the definition of a liability because they do not arise from a past transaction but
instead relate to future events.
Some companies take out insurance policies against the potential losses from fire, flood, storm,
and accident. Other companies do not. The reasons: Some risks are not insurable, the insurance
rates are prohibitive (e.g., earthquakes and riots), or they make a business decision to self-insure.
Self-insurance is another item that is not recognized as a contingency.
Despite its name, self-insurance is not insurance, but risk assumption. Any company that
assumes its own risks puts itself in the position of incurring expenses or losses as they occur.
There is little theoretical justification for the establishment of a liability based on a hypothetical
charge to insurance expense. This is “as if” accounting.
The conditions for accrual stated in GAAP are not satisfied prior to the occurrence of the event.
Until that time there is no diminution in the value of the property. And unlike an insurance
company, which has contractual obligations to reimburse policyholders for losses, a company
can have no such obligation to itself and, hence, no liability either before or after the occurrence
of damage. The note in the following illustration from the annual report of Adolph Coors
Company is typical of the self-insurance disclosure.

Exposure to risks of loss resulting from uninsured past injury to others, however, is an
existing condition involving uncertainty about the amount and timing of losses that may
develop. In such a case, a contingency exists. A company with a fleet of vehicles for example,
would have to accrue uninsured losses resulting from injury to others or damage to the property
of others that took place prior to the date of the financial statements (if the experience of the
company or other information enables it to make a reasonable estimate of the liability).
However, it should not establish a liability for expected future injury to others or damage to
the property of others, even if it can reasonably estimate the amount of losses.
 PRESENTATION AND ANALYSIS
PRESENTATION OF CURRENT LIABILITIES

In practice, current liabilities are usually recorded and reported in financial statements at their
full maturity value. Because of the short time periods involved, frequently less than one year,
the difference between the present value of a current liability and the maturity value is usually
not large. The profession accepts as immaterial any slight overstatement of liabilities that results
from carrying current liabilities at maturity value.
The current liabilities accounts are commonly presented as the first classification in the
liabilities and stockholders’ equity section of the balance sheet. Within the current liabilities
section, companies may list the accounts in order of maturity, in descending order of amount, or
in order of liquidation preference. The following illustration presents an excerpt of Best Buy
Company’s financial statements that is representative of the reports of large corporations.

Detail and supplemental information concerning current liabilities should be sufficient to meet
the requirement of full disclosure. Companies should clearly identify secured liabilities, as well
as indicate the related assets pledged as collateral. If the due date of any liability can be
extended, a company should disclose the details.
Companies should not offset current liabilities against assets that it will apply to their
liquidation. Finally, current maturities of long-term debt are classified as current liabilities.
A major exception exists when a company will pay a currently maturing obligation from
assets classified as long-term. For example, if a company will retire a bond payable using a
bond sinking fund that is classified as a long-term asset, it should report the bonds payable in
the long-term liabilities section. Presentation of this debt in the current liabilities section would
distort the working capital position of the enterprise.
If a company excludes a short-term obligation from current liabilities because of refinancing, it
should include the following in the note to the financial statements:
1. A general description of the financing agreement.
2. The terms of any new obligation incurred or to be incurred.
3. The terms of any equity security issued or to be issued.
When a company expects to refinance on a long-term basis by issuing equity securities, it is not
appropriate to include the short-term obligation in stockholders’ equity. At the date of the
balance sheet, the obligation is a liability and not stockholders’ equity.
Illustration below shows the disclosure requirements for an actual refinancing situation.

PRESENTATION OF CONTINGENCIES
A company records a loss contingency and a liability if the loss is both probable and estimable.
But, if the loss is either probable or estimable but not both, and if there is at least a
reasonable possibility that a company may have incurred a liability, it must disclose the
following in the notes.
1. The nature of the contingency.
2. An estimate of the possible loss or range of loss or a statement that an estimate cannot be
made.
Illustration below presents an extensive litigation disclosure note from the financial statements
of Raymark Corporation. The note indicates that Raymark charged actual losses to operations
and that a further liability may exist, but that the company cannot currently estimate this
liability.
Companies should disclose certain other contingent liabilities, even though the possibility of
loss may be remote, as follows.
1. Guarantees of indebtedness of others.
2. Obligations of commercial banks under “stand-by letters of credit.”
3. Guarantees to repurchase receivables (or any related property) that have been sold or
assigned.
Disclosure should include the nature and amount of the guarantee and, if estimable, the amount
that the company can recover from outside parties.Cities Service Company disclosed its
guarantees of others’ indebtedness in the following note.
ANALYSIS OF CURRENT LIABILITIES
The distinction between current liabilities and long-term debt is important. It provides
information about the liquidity of the company. Liquidity regarding a liability is the expected
time to elapse before its payment. In other words, a liability soon to be paid is a current liability.
Aliquid company is better able to withstand a financial downturn. Also, it has a better chance of
taking advantage of investment opportunities that develop.
Analysts use certain basic ratios such as net cash flow provided by operating activities to
current liabilities, and the turnover ratios for receivables and inventory, to assess liquidity. Two
other ratios used to examine liquidity are the current ratio and the acid-test ratio.

Current Ratio
The current ratio is the ratio of total current assets to total current liabilities. The follow shows
its formula. Current Ratio = Current Asset
Current Liability
The ratio is frequently expressed as coverage of so many times. Sometimes it is called the
working capital ratio because working capital is the excess of current assets over current
liabilities. A satisfactory current ratio does not disclose that a portion of the current assets may
be tied up in slow-moving inventories. With inventories, especially raw materials and work in
process, there is a question of how long it will take to transform them into the finished product
and what ultimately will be realized in the sale of the merchandise.
Eliminating the inventories, along with any prepaid expenses, from the amount of current assets
might provide better information for short-term creditors. Therefore, some analysts use the acid-
test ratio in place of the current ratio.

Acid-Test Ratio
Many analysts favor an acid-test or quick ratio that relates total current liabilities to cash,
marketable securities, and receivables. The following shows the formula for this ratio. As you
can see, the acid-test ratio does not include inventories.

To illustrate the computation of these two ratios, we use the information for Best Buy Co.
above. Below is the computation of the current and acid-test ratios for Best Buy.
From this information, it appears that Best Buy’s current position is adequate. However, the
acid-test ratio is well below 1. A comparison to another retailer, Circuit City, whose current
ratio is 1.68 and whose acid-test ratio is 0.65, indicates that Best Buy is carrying fewer
inventories than its industry counterparts.